The Financial Accounting Standards Board (FASB) has proposed significant changes to the way leases are accounted for under Generally Accepted Accounting Principles (GAAP). FASB seeks to modify Financial Accounting Standard No. 13 (FAS 13), which is the current standard for lease accounting. The public comment period for FASB’s proposed changes to FAS 13 ended in late 2010. FASB is currently reviewing the comments to determine whether the new FAS 13 should remain as written or if the new rule should be revised to reflect points raised during the comment period. The final FAS 13 is anticipated in June 2011. This Alert provides a brief look at the proposed FAS 13 and also discusses the feedback FASB has received on the new rule.

At a Glance

The new FAS 13 will require landlords and tenants to capitalize real property and equipment leases with a lease term of greater than one year. Capitalization requires that parties recognize an asset and corresponding liability on their balance sheet, while also recording interest expense and amortization expense on the income statement. This is a departure from the current standard in which most leases do not receive any recognition on the balance sheet and only straight-line rent expense is recorded on the income statement. FASB hopes these changes will bring increased accuracy to financial statements as readers will be able to see exactly what effect leases have on an entity’s books, but skeptics maintain that grossing up balance sheets and increasing expenses on the income statement will create unnecessary financial statement upheaval that could impact the way leases are structured and an entity’s ability to obtain financing.

While FAS 13 is still being reviewed by FASB and there is no guarantee it will contain all the changes described here, it is important that landlords and tenants plan ahead because there will be no “grandfathering” of the rule. In order to be ready for the anticipated changes required by the new FAS 13, landlords and tenants should begin to:

1. Review current leases to determine how they would be affected by the new FAS 13 financial statement reporting standard.
2. Discuss accounting changes with accountants and brokers to understand the costs associated with the new FAS 13 (for example, determine whether there will be there be increased accounting and auditing costs to ensure leases are properly recorded on the financial statements).
3. Review existing loan agreements to determine what impact changes in earnings ratios and leverage ratios will have on existing debt covenants.
4. Talk to lenders about whether existing debt covenants need to be revised.
5. Analyze the tax implications of the new FAS 13.
6. Begin to discuss with investors the effect FAS 13 may have on performance metrics such as net income, depreciation and amortization.

The New Potential “X” Factors

The new FAS 13 requires tenants to make a number of judgment calls at the beginning of a lease term, which prompts many to ask whether these judgments actually make the new lease accounting rules more or less reliable than the current rules.

Tenants will need to make the following determinations using expected outcome analysis:

1. The lease term to be used is the longest term most likely to occur (taking into consideration renewal options).
2. The tenant must estimate contingent rentals. Contingent rentals are items that are not included in negotiated lease payments but that increase these payments after the commencement of a lease. An example of a contingent rental is when a tenant must pay a percentage of sales to the landlord as additional rent.
3. The tenant must estimate residual value guarantees.

Tenants will be required to reassess the analysis above each reporting period and as changes occur, they will need to adjust their financial statement reporting as necessary.

FAS 13 Feedback

The FASB is currently in the process of reviewing comments to the proposed FAS 13. The new rule may be altered to incorporate some of the feedback received. It appears that most of the commentary on the new rule was focused on the three major areas discussed below.

First, many respondents took issue with charging depreciation and amortization expense against income primarily because it results in lower earnings in the early part of a lease term. In response to this point, the FASB is considering creating two categories of leases: Finance Leases and Other than Finance Leases. A lease classified as a Finance Lease would require interest expense and amortization expense recordation on the income statement, consistent with the principles outlined in the proposed FAS 13. A lease classified as an Other than Finance Lease would require straight-line rent expense be recorded on the income statement similar to the manner in which operating leases are currently accounted for under FAS 13. The FASB is in the process of establishing the distinctions between a Finance Lease and an Other than Finance Lease. In February 2011, the FASB decided to work on indicators to distinguish these two categories. Many hope that real estate leases would be categorized as Other than Finance Leases, which would result in little change in accounting recognition for these leases.

Second, many comments indicated that the definition of a lease under the proposed FAS 13 is too broad and may encompass some service contracts. The FASB is currently considering whether to re-tool the definition of a lease so as to avoid capturing capitalization of an asset that is incidental to an underlying service provided.

Third, as discussed above in the section entitled “The New Potential X Factors,” the proposed FAS 13 asks that tenants make a variety of projections with respect to lease terms/renewal options, contingent rentals and residual value guarantees. Not surprisingly, many comments disagreed with building these projections into lease accounting. Because many respondents suggested that a renewal option not become a liability until after a tenant has exercised the option, the FASB is considering whether to change the proposed FAS 13 to reflect a higher threshold for including lease renewal options in calculating the lease term. For instance, they may only be included in the lease accounting analysis when it is reasonably assured the renewal will be exercised such as when there is a significant economic incentive to exercise the renewal option. With respect to projections regarding contingent rentals and residual value guarantees, many respondents suggested this approach could bring an unnecessary volatility to earnings. The FASB is in the process of determining if this should be revised to eliminate these requirements from the final rule.

And Finally…

Even though FAS 13 is currently in the re-tooling stage, the rule in its final form will no doubt bring significant changes to lease accounting as we currently know it. But hopefully the new rule should function as a mere disruption and not as a change that deeply impacts lease negotiation and entity financing. Once landlords, tenants, investors, lenders and others in the business community begin to understand what the new FAS 13 means and how to prepare for its implementation, the rule should have little, if any, negative long term effect.

For a more detailed explanation of proposed changes to FAS 13, please click here.